Three ways to make the market's volatility work for you.
By Janice Revell, Money Magazine senior writer
November 6 2007: 9:03 AM EST
(Money Magazine) -- Let's face it: As investors, we've been spoiled. A study by Wilshire Consulting shows that from 2004 to 2006, volatility in the U.S. stock market was almost freakishly low - in fact, over the past 30 years, there was only one other stretch (1993 to 1996) when the market was as calm.
That's history now, and the turbulence that erupted last summer looks to continue next year. But you can make that volatility work to your advantage.
The best strategy in a rocky market is to stay in the game. As long as you're investing over a long enough period for the market to recover from a severe drop - about seven to 10 years - you will almost always be better off staying invested and continuing to pick up additional shares on market dips.
Consider the outcome if you had contributed, say, $400 every two weeks to your 401(k) plan and invested it in a low-cost stock fund like Vanguard's S&P 500 index fund during a volatile period like the third quarter of 2007.
By the end of September, the S&P 500 had just barely recovered from the 10% plunge it took in July and August, when the credit crisis was in full swing. For the full three months, the index fund eked out a gain of just 0.4%.
But because you'd have scooped up more shares for each $400 contribution when the market was falling, you would have racked up a 2.7% gain on your 401(k) contributions for the third quarter - a return that most professional money managers would have killed for.
By the way, you would have gotten the same type of great returns if you had been buying stocks right after the crash of 1987 - or after any other big drop - as long as you had stuck with your picks a few years.
"It's during times of volatility, the scary times, that your discipline pays off," notes Stephen Wood, senior portfolio strategist at Russell Investment Group.
Think big
The combination of a slowing U.S. economy and the weaker dollar weighs heavily in favor of large-cap growth stocks like General Electric and Cisco that can rely on their foreign operations to prop up their earnings when the U.S. slows down.
And unlike smaller companies, which have registered strong price gains over the past few years, large companies still look inexpensive heading into 2008.
"You're getting some of the bluest of the blue-chip companies at bargain-basement prices," says Bob Turner, chief investment officer of Turner Investment Partners.
Within the Money 70, our list of recommended mutual and exchange-traded funds, solid large-cap growth choices include American Funds Amcap (AMCPX (Charts), T. Rowe Price Blue Chip Growth (TRBCX (Charts) and Jensen (JENSX (Charts).
In fixed income, go for high quality
Compared with stocks, bonds may not look like an overly appealing investment for 2008. After all, the Federal Reserve's recent rate cuts have depressed bond yields, enhancing the relative appeal of stocks.
Ten-year Treasury bonds, for instance, were recently yielding just 4.4%. But unless you've got an ironclad stomach, owning some bonds will be particularly important next year.
Those yields will provide a much needed buffer against the sharp ups and downs of the stock market.
Given the general concerns about credit quality, favor highly rated bonds. Sticking with shorter maturities also makes sense. The weakening dollar could fuel inflation, which would seriously erode the returns on longer-term bonds.
Some top-quality selections from the Money 70 whose bond portfolios match that description: Dodge & Cox Income (DODIX (Charts), FPA New Income (FPNIX (Charts) and Vanguard Short-Term Bond Index (VBISX (Charts).
